Janet Yellen gave a speech earlier this month where she suggested that the Fed should run a “high-pressure” economy in an effort to fix structural damage done to the supply-side of the economy by the financial crisis.
What is a “high pressure” economy? Here’s Yellen’s explanation and justification (emphasis is mine).
If we assume that hysteresis is in fact present to some degree after deep recessions, the natural next question is to ask whether it might be possible to reverse these adverse supply-side effects by temporarily running a “high-pressure economy,” with robust aggregate demand and a tight labor market. One can certainly identify plausible ways in which this might occur. Increased business sales would almost certainly raise the productive capacity of the economy by encouraging additional capital spending, especially if accompanied by reduced uncertainty about future prospects.
To summarize, Yellen is suggesting that by running a hot economy (read continuing to stimulate when stimulus is not needed), the economy will be able to produce more, thereby increasing growth. Running a hot economy may indeed increase how much the economy can produce, but if the tech and real estate bubbles are any guide, running a hot economy, doesn’t lead to a balanced increase in productive capacity. Instead, it leads to massive overcapacity in certain sectors of the economy which ultimately creates more, not fewer, problems for growth.
Holding interest rates far below where conventional monetary policy rules suggests they should be, also risks an outbreak of inflation (the 1970s are your example here) and a further escalation of bubble conditions in the financial markets.
What are the investment implications of a Federal Reserve that may be looking to run the economy hot? Start focusing more on asset bubbles.
The Fed acknowledges that holding rates so low for so long risks financial instability (bubbles), but many on the Fed continue to assure the public there are no bubbles to worry about today.
That’s a little rich coming from the same Fed that didn’t see the real estate bubble and then downplayed it and the same Fed who stood by while the greatest stock market bubble in U.S. history inflated.
We would offer a different perspective on the presence of bubble conditions in financial markets today.
For example, the price-to-sales ratio of the S&P 500 has only been higher once during the last seven decades and that was during the dotcom bubble.
Interest rates are near their lowest levels in 5,000 years of recorded history.
Commercial real estate prices are at a record highs, and capitalization rates are at or near record lows.
Investors are reaching for yield and return with little regard for risk. There are many examples of yield reaching in markets, but this clipping from the WSJ sums things up nicely.
Venezuela is plagued by widespread hunger, skyrocketing infant mortality and 500% inflation. Yet its sovereign bonds are the best performers in emerging markets this year, delivering investors a return of 46% through Friday.
Really, Venezuelan bonds?
The ugly reality is that a Fed decision to run a high-pressure economy may cause a final blow-off phase in markets that will cause some relative performance discomfort for those who aren’t willing to play the great fool theory of investing with their serious money. The proper approach for successfully navigating such an environment is a patient approach and a focus on your own investment goals and objectives.